481 Golden Words on Transaction Cost Economics

Ronald Henry Coase's Noble Prize lecture contains some 481 golden words on transaction cost economics.

They are worth a very good and repeated read. In his lecture, Coase gives a very classical example of the application of transaction cost economics to explain why money exists. Of course, the answer is obvious. What is interesting is the casting of it in terms of transaction cost economics, an approach which becomes most interesting when authors like Douglass North apply it to the evolution of economic structures through history.

I argued in "The Nature of the Firm" that the existence of transaction costs leads to the emergence of the firm. But the effects are pervasive in the economy. Businessmen in deciding on their ways of doing business and on what to produce have to take into account transaction costs. If the costs of making an exchange are greater than the gains which that exchange would bring, that exchange would not take place and the greater production that would flow from specialisation would not be realised. In this way, transaction costs affect not only contractual arrangements but also what goods and services are produced. Not to include transaction costs in the theory leaves many aspects of the working of the economic system unexplained, including the emergence of the firm, but much else besides. In fact, a large part of what we think of as economic activity is designed to accomplish what high transaction costs would otherwise prevent or to reduce transaction costs so that individuals can freely negotiate and we can take advantage of that diffused knowledge of which Hayek has told us.

I know of only one part of economics in which transaction costs have been used to explain a major feature of the economic system and that relates to the evolution and use of money. Adam Smith pointed out the hindrances to commerce that would arise in an economic system in which there was a division of labour but in which all exchange had to take the form of barter. No-one would be able to buy anything unless he possessed something that the producer wanted. This difficulty, he explained, could be overcome by the use of money. A person wishing to buy something in a barter system has to find someone who has this product for sale but who also wants some of the goods possessed by the potential buyer. Similarly, a person wishing to sell something has to find someone who both wants what he has to offer and also possesses something that the potential seller wants. Exchange in a barter system requires what Jevons called "this double coincidence".

Clearly the search for partners in exchange with suitable qualifications is likely to be very costly and will prevent many potentially beneficial exchanges from taking place. The benefit brought about by the use of money consists of a reduction in transaction costs. The use of money also reduces transaction costs by facilitating the drawing up of contracts as well as by reducing the quantity of goods that need to be held for purposes of exchange. However, the nature of the benefits secured by the use of money seems to have faded into the background so far as economists are concerned and it does not seem to have been noticed that there are other features of the economic system which exist because of the need to mitigate transaction costs.

Ronald H. Coase, 1991 Nobel Prize Lecture, "The Institutional Structure of Production"

The lecture, along with several other pieces, can also be found in Coase's 1994 book, Essays on Economics and Economists.

Note: Word count was done on OpenOffice!


Very interesting.

Do you know if anyone has done an analysis, in these terms, of how the transaction costs differ between cash systems and e-cash systems?

Posted by Robin Wilton on March 01, 2006 at 06:09 PM PST #

Note that Coase is talking about "money" as medium of exchange vs. barter. In this essay, at least, he does not address the differences among forms of money, whether e-cash or paper-cash. In looking at money, he is in the same camp as those who speak of monetary system and mean all forms of money in that monetary system.

Nevertheless, the relative transaction costs of various forms of "money" is still a good subject for study. In fact, e-cash will win if it can (in action, organically and "naturally") prove to reduce transaction costs.

These topics can definitely feed into various research projects with great promise and productivity. Some minor attempts may have been made in European economic research centers.

In fact, application of TCE to various e-businss and m-business models is a great way to confirm basic validity of these models.

E-cash systems have transaction costs that are unique to them that do not exist in the paper cash system and vice versa.

By the way, U.S. tax laws tax exchange without any care on whether they are barter or through a medium other than barter, say money.

In Douglass North's terms, this is a great example of how governments tax transactions as a way of funding their monopoly on governance and monitoring of "rules of the game" so to speak.

Posted by M. Mortazavi on March 02, 2006 at 01:01 AM PST #

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